Saturday, May 9, 2009

Christopher Flower’s short memory

I play in bank stocks. Christopher Flowers is a name I see again and again.

He is a private equity guy - and he buys banks. Big banks. Lots of money. And superficially that is appealing from a policy perspective. After all private equity (Carlyle, Flowers, Cerberus et al) have capital and the government is usually pleased when new private capital comes into banks in the height of a banking crisis. The issue was played in the New York Times (hat tip to and some decent analysis from Felix Salmon).

Its just that private equity make very unsuitable owners for a bank. Frightfully unsuitable.

The problem is that banks take guaranteed deposits (or at least deposits that need to be bailed out if the bank is insolvent) and private equity owns a whole lot of levered buy-outs and the like. And if a small private equity firm owns a bank it could become a large private equity firm by lending to related parties. There are very few entities as complicated and with as many conflicts as a large PE firm borrowing money from banks they control.

Mr Flowers puts his case in the New York Times article:

“I don’t think the Republic is going to be brought to its knees if private equity owns banks, personally,” Mr. Flowers said from his Midtown Manhattan office with its expansive views of Central Park. “We invest around the world — Japan, Germany, England, no problem.”

Effectively he says the conflicts can be managed.

Well – if you really want to be sure of that just go have a look at the results of Shinsei and Aozora. These were Japanese banks with controlling stakes from Flowers and Cerberus respectively. When Aozora floated it had made very good profits by investing in other American private equity ventures.

Flowers also invested in relatively risky structures in the US and Europe through his effective control over Shinsei. Indeed the memory is very short – this Bloomberg article talks about Shinsei’s and Aozora’s recent results in the light of this conflict of interest. It seems the bailout of Japan’s banks last time caused a sowed the seeds for another round of problems in Japan’s banks. The New York Times alludes to this conflict of interest – but the conflict of interest has been around a long time – in good times and bad. Aozora’s float – laden with what were then private equity profits – was years ago. These guys are hardened professionals at conflict of interest in banking.

Or as the Bloomberg article puts it:

Shinsei racked up profits in its first six years under foreign ownership. The bank gave funds to J.C. Flowers to invest and had no discretion where Flowers placed the money, Flowers said. Neither Shinsei nor Flowers would give the amount.

The New York Times notes that the Federal Reserve strictly controls who can own a bank – and for good reason. They also note that Mr Flowers has hired top tier Washington Lobbyists to try to get regulatory changes that suit him.

If he manages to get Washington to listen to him then I fear for your republic. This might not – as Mr Flowers notes – bring the Republic to its knees – but it is another step on the way to lemon socialism owned and controlled by the plutocracy.

7 comments:

IF
said...

It is interesting to see in how much trouble this guy is involved in around the world. I mostly follow the HRE saga. After offering him above par for his shares in HRE, the German government might nationalize (real capitalists?) It is not clear to me from the article if this would wipe out Flowers himself, or a Japanese bank (I mean tax payer). Some chain reaction! It is such events which make me doubtful about the scope of future financial globalization. Very hard to explain tax payers why they should suffer as a result of foreign adventures.

Federal Reserve regulations O and W already limit transactions with principal shareholders and affiliates. If the regulations need modification to cover private equity, and prevent risky related investing, that is easy to do.

Bank holding companies that own more than one bank also face the same incentives and problems that you raise about private equity. They can use one bank to loan and invest in the other. Regulations exist to limit this activity. The rules can be changed, if needed, to cover any loopholes for private equity.

Similarly, there are rules to prevent double leverage in a bank where the bank holding company uses its debt and equity to invest it all as equity in a subsidiary bank, which then leverages that apparent equity.

Intentional violations of the regulations are severe for directors and executives, including criminality, civil penalties, divestiture, and permanent exclusion from the industry as a director, employee, consultant or controlling shareholder.

Additionally, private equity that owns a bank would become a bank holding company and would need to file a consolidated entity financial statement. If private equity finds a way around these rules, the Fed has the power to modify the rules or to require it as a condition of bank ownership. The financial statement would show inter-entity loans.

Commercial entities already own bank equivalent institutions, such as industrial banks, and unitary savings and loans without problems.

The biggest problem is the banks' political lobby, which is fearful of the competition from successful non-banking companies. Just look at all the opposition to Wal-Mart's attempt to own an industrial bank simply so it could become part of the check and credit card processing network and save money.

Christopher Flowers is getting his fingers badly burned here in Germany. He bought into Hypo Real Estate (HRE) last April when the company was already on the way down. Now it is essentially insolvent - the capital cover is below 4% and the bank should actually already have been closed according to German banking law. The German parliament has passed a law to nationalise the bank. Flowers isn't happy with the price being offered - he bought at EUR 22 50 is being offered less than EUR 2. However, anything is good value for shares in a company so messed up it probably has negative net worth, and will probably lose a further few million on lawsuits chasing the billion euros or so he has already lost on Hypo Real Estate (HRE). I try not to smile.

Milton Reich thinks that controlling related party lending is easy to do.

I guess it was when Charles Keating et al looted S&Ls too...

Its almost impossible to control principal agent problems in stock ownership. Work out how hard it is - even with a 15% stake - to sack a board with no stake... and even when a majority of shareholders almost certainly agree with you.

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It is touching how much the right distrust regulation sometimes and trust it others...

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It is far better NOT to have conflicts of interest than to regulate them.

S&L's are not supervised or regulated by the Federal Reserve. S&L regulations come from OTS (Office of Thrift Supervision) and are much more relaxed than Fed Reserve regs. It is exactly because S&Ls had easy regs that Keating chose one and used it to finance his empire.

The AIG unit that had all the derivative losses and caused the failure of AIG was also supervised by OTS.

Commercial banks are much more strictly supervised by the FED than S&Ls are by OTS.

You are right that in a corporation, it is difficult to dislodge a board or CEO. However, banks have FED bank examiners and the FED can force a board member or bank CEO out. It has replaced CEO and board members many times with banks that have run into problems.

I cannot answer the obvious question as to why the top banks that are in trouble currently are able to keep their boards and CEOs.

Principal agent problem exist in banks currently with or without private equity. Why should one source of equity make it worse than the other.

When Flowers is talking about PE being involved in banks I think he's just referring to ownership. Since most financial PE firms don't use leverage, I doubt he's referring to the possibility of lending to either his funds or other portfolio companies. And I'm pretty sure he has little interest in exposing his banks to leveraged lending (that is, other PE firms' portfolio companies).

I don't see this as a big deal. The industry needs the capital.

Having said that, Flowers, like many others of his era, made 99% of his fortune in the period 1991 to 2007... which was basically just one upward move with a few minor bumps. Basically anyone who leveraged real estate and/or banks from 1991 onward made a fortune... until recently. And most of these folks - a la Flowers - now have their tits in a wringer big time. Because it never occurred to them that an unwind like the present one was a possibility - it has no precedent as part of their professional history.

I'm in banking and I hear that Flowers is a very smart guy (and I've heard some funny stories that suggest the contrary as well), but how smart are you, really, if you can't make it through a downturn? That's a rhetorical question.

More Flowers bank "blowups": NIB Capital and HSH Nordbank. The latter owns a huge portfolio of US subprime RMBS and related securities. Given he is alum of that famous firm, one might not be surprised if he "manages to get Washington to listen to him".

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